Creative Finance 201: How to Use a HELOC to Invest in Real Estate
If you are a homeowner who wants to invest in real estate, you may have a valuable source of financing right under your roof. A home equity line of credit (HELOC) is a type of loan that lets you borrow against the equity in your home and use the funds for any purpose, including buying or improving another property. It is best used for short term loan needs due to how HELOCs are structured.
A HELOC can be a powerful tool for real estate investors, as it offers flexibility, accessibility, and low interest rates compared to other forms of financing. However, a HELOC also comes with some challenges and risks, such as finding a lender, qualifying for the loan, and following the rules and regulations.
In this article, we will explain what a HELOC is, how it works, and how you can use it to invest in real estate. We will also cover the benefits and drawbacks of using a HELOC for real estate investing, and provide some tips and best practices to help you succeed.
What is a HELOC and How Does it Work?
A HELOC, or a home equity line of credit, is a type of loan that allows you to borrow money from the equity in your home. Equity is the difference between the value of your home and the amount you owe on your mortgage. For example, if your home is worth $300,000 and you owe $200,000 on your mortgage, you have $100,000 in equity.
A HELOC works like a credit card, where you have a credit limit and you can withdraw money as you need it, up to that limit. You only pay interest on the amount you borrow, not on the entire credit line. You can use the money for any purpose, such as home improvements, debt consolidation, or investing in real estate.
However, unlike a credit card, a HELOC is secured by your home, which means that if you fail to repay the loan, the lender can foreclose on your property. A HELOC also has a variable interest rate, which means that it can change over time depending on the market conditions and the lender’s margin. A HELOC typically has two phases: a draw period and a repayment period.
The draw period is the time when you can access the funds from your HELOC, usually between 5 to 10 years. During this period, you can withdraw money as you need it, and you only have to pay the interest on the balance. You can also repay some or all of the principal during this period, which will free up more credit for you to use.
The repayment period is the time when you have to pay back the principal and interest on your HELOC, usually between 10 to 20 years. During this period, you can no longer withdraw money from your HELOC, and you have to make monthly payments that include both principal and interest. The payments may increase significantly compared to the draw period, depending on the interest rate and the balance.
To qualify for a HELOC, you need to have enough equity in your home, a good credit score, a stable income, and a low debt-to-income ratio. You can use a HELOC on your primary residence, which is the most common, or an investment property. If you pursue a HELOC on an investment property, you will need to find a lender that offers a HELOC, which may be harder and more expensive than a HELOC on a primary residence. You should also be aware of the rules and regulations, the costs and fees, and the risks and rewards of using a HELOC to invest in real estate.
Difference Between HELOC and Home Equity Loan
A HELOC is a line of credit that lets you borrow money as you need it, up to a limit, and pay interest only on what you borrow. A home equity loan is a lump sum loan that gives you a fixed amount of money and requires you to pay back the principal and interest in fixed monthly payments, usually within 5 to 15 years. Both are secured by your home equity.
Both a HELOC and a home equity loan can offer low-cost, credit-based funding, but they have different advantages and disadvantages depending on your needs and goals. A HELOC can offer more flexibility and accessibility, but also more risk and uncertainty. A home equity loan can offer more stability and predictability, but also less control and opportunity. You should compare the costs, fees, and terms of both options before deciding which one is right for you.
How to Qualify for a HELOC
One of the first steps to using a HELOC to invest in real estate is to qualify for the loan. To do so, you need to meet certain criteria based on your credit score, income, debt-to-income ratio, and equity. These criteria may vary depending on the lender, but generally, you need to have:
A good credit score: Most lenders require a minimum credit score of 620 to 680 to approve a HELOC, but some may have higher or lower standards. A higher credit score can help you get a lower interest rate and a higher credit limit.
A sufficient income: You need to have a steady and verifiable income that can cover the monthly payments of your HELOC, as well as your other debts and expenses. Lenders may ask for your tax returns, pay stubs, bank statements, and other documents to verify your income.
A low debt-to-income ratio: Your debt-to-income ratio (DTI) is the percentage of your monthly income that goes toward paying your debts, such as your mortgage, car loan, credit card, and HELOC. Lenders typically prefer a DTI of 36% or lower, but some may accept higher ratios depending on your credit score and equity.
A sufficient equity: Your equity is the difference between the value of your home and the amount you owe on your mortgage. You need to have enough equity to borrow against with your HELOC. Most lenders allow you to borrow up to 80% to 85% of your home’s value, minus your mortgage balance. For example, if your home is worth $300,000 and you owe $200,000 on your mortgage, you have $100,000 in equity. If your lender allows you to borrow up to 80% of your home’s value, you can get a HELOC of up to $40,000 ($300,000 x 80% - $200,000).
If you meet these criteria, you can apply for a HELOC with your lender of choice. However, keep in mind that qualifying for a HELOC does not guarantee that you can use it to invest in real estate. You also need to find a lender that offers a HELOC on an investment property, which leads us to the next point.
Terms You Need to Know Before Getting a HELOC
Not all lenders offer a HELOC on an investment property, as it is considered a riskier loan than a HELOC on a primary residence. An investment property is more likely to experience vacancies, damages, or depreciation, which can affect your ability to repay the loan. Moreover, if you default on your HELOC, the lender may have a harder time foreclosing on an investment property than on a primary residence, as there may be legal and logistical hurdles involved.
Therefore, you may have to shop around and compare different lenders and offers to find a HELOC on an investment property. Some of the factors that you need to consider are:
The interest rate: The interest rate is the cost of borrowing money with your HELOC. It is usually variable, meaning that it can change over time based on the market conditions and the lender’s margin. The interest rate can affect your monthly payments and your total cost of borrowing. Generally, the lower the interest rate, the better for you.
The credit limit: The credit limit is the maximum amount of money that you can borrow with your HELOC. It is based on your equity, your credit score, your income, and your debt-to-income ratio. The credit limit can affect your borrowing power and your flexibility. Generally, the higher the credit limit, the better for you.
The fees and charges: The fees and charges are the additional costs of getting and using a HELOC. They may include an application fee, an origination fee, an appraisal fee, an annual fee, a transaction fee, a prepayment penalty, and a cancellation fee. The fees and charges can affect your upfront and ongoing expenses. Generally, the lower the fees and charges, the better for you.
The terms and conditions: The terms and conditions are the rules and regulations that govern your HELOC. They may include the draw period, the repayment period, the minimum and maximum withdrawal amounts, the minimum and maximum payment amounts, the late payment penalties, and the default consequences. The terms and conditions can affect your rights and responsibilities. Generally, the more favorable the terms and conditions, the better for you.
By comparing different lenders and offers, you can find a HELOC on an investment property that suits your needs and goals. However, you also need to avoid any prohibited transactions or disqualified persons, which brings us to the next point.
Avoiding Prohibited Transactions or Disqualified Persons
One of the most important rules to follow when using a HELOC to invest in real estate is to avoid any prohibited transactions or disqualified persons. According to the IRS, a prohibited transaction is any improper use of your HELOC by you, your beneficiary, or any disqualified person. A disqualified person is any person who has a direct or indirect interest or influence over your HELOC, such as your spouse, your children, your parents, your business partners, or your fiduciaries.
Some examples of prohibited transactions or disqualified persons are:
Using your HELOC to buy or improve a property that you or any disqualified person will use or benefit from personally, such as a primary residence, a second home, a vacation home, or a business property.
Using your HELOC to lend money to or borrow money from any disqualified person, such as your spouse, your children, your parents, or your business partners.
Using your HELOC to sell or exchange property with any disqualified person, such as your spouse, your children, your parents, or your business partners.
Using your HELOC to pay compensation or fees to any disqualified person, such as your spouse, your children, your parents, your business partners, or your fiduciaries.
If you engage in any prohibited transactions or disqualified persons, you may face severe penalties and taxes, and even lose your HELOC status. Therefore, you need to be careful and diligent when using your HELOC to invest in real estate, and consult with a professional before making any decisions. You also need to follow the IRS regulations and tax implications, which leads us to the next point.
Following The IRS Regulations and Tax Implications
Another important rule to follow when using a HELOC to invest in real estate is to follow the IRS regulations and tax implications. According to the IRS, the interest that you pay on your HELOC is deductible only to the extent that the balance on your HELOC is used to buy, build, or substantially improve the home that secures the debt. This means that you cannot deduct the interest on the portion of your HELOC that is used for other purposes, such as investing in real estate.
However, you may be able to deduct the interest on your HELOC as a business expense if you use it to invest in real estate that is used for business purposes, such as rental properties, fix and flip properties, or commercial properties. To do so, you need to meet certain criteria, such as:
The property must be used exclusively and regularly for business purposes, and not for personal use or enjoyment.
The property must generate income or profit from the business activity, and not from the appreciation in value.
The property must be held for more than one year, and not for short-term speculation or resale.
The property must be reported and accounted for as a separate business entity, and not as a personal asset.
If you meet these criteria, you may be able to deduct the interest on your HELOC as a business expense, subject to some limitations and exceptions. However, you also need to report and pay taxes on the income or gains that you earn from your real estate investment, such as rent, interest, dividends, or capital gains. The tax rate and the tax treatment may vary depending on the type and the duration of your real estate investment, as well as your income level and your filing status.
Therefore, you need to keep track of your income and expenses, and report them accurately and timely to the IRS and your state. You also need to consult with a tax professional to determine the best tax strategy and the optimal tax outcome for your situation. You also need to avoid some common pitfalls and mistakes that can cost you money and trouble, which brings us to the next point.
Common Mistakes Made Using HELOCs
Using a HELOC to invest in real estate can be a rewarding and profitable venture, but it also requires careful planning and execution. There are some common pitfalls and mistakes that you need to avoid, such as:
Overborrowing or overspending your HELOC funds: One of the biggest risks of using a HELOC to invest in real estate is to overborrow or overspend your HELOC funds. This can happen if you underestimate the costs and fees of your real estate investment, or if you overestimate the income and returns of your real estate investment. This can also happen if you use your HELOC funds for other purposes, such as personal or recreational expenses. If you overborrow or overspend your HELOC funds, you may end up with a high debt and a low equity, which can affect your credit score, your cash flow, and your ability to repay the loan.
Missing or defaulting on your HELOC payments: Another major risk of using a HELOC to invest in real estate is to miss or default on your HELOC payments. This can happen if you have insufficient income or cash flow to cover the monthly payments, or if you encounter unexpected expenses or emergencies. This can also happen if you fail to plan ahead for the repayment period, when your payments may increase significantly. If you miss or default on your HELOC payments, you may face late fees, penalties, higher interest rates, or even foreclosure of your property.
Violating the terms and conditions of your HELOC agreement: A third common risk of using a HELOC to invest in real estate is to violate the terms and conditions of your HELOC agreement. This can happen if you fail to follow the rules and regulations of your lender, such as the minimum and maximum withdrawal amounts, the minimum and maximum payment amounts, the late payment penalties, and the default consequences. This can also happen if you fail to notify your lender of any changes in your personal or financial situation, such as a job loss, a divorce, or a bankruptcy. If you violate the terms and conditions of your HELOC agreement, you may face fines, lawsuits, or termination of your HELOC.
Failing to report or pay taxes on your HELOC income or gains: A fourth common risk of using a HELOC to invest in real estate is to fail to report or pay taxes on your HELOC income or gains. This can happen if you neglect or forget to keep track of your income and expenses, or if you misunderstand or misapply the tax rules and regulations. This can also happen if you try to evade or avoid taxes by hiding or underreporting your income or gains. If you fail to report or pay taxes on your HELOC income or gains, you may face audits, penalties, or criminal charges.
These are some of the common pitfalls and mistakes that you need to avoid when using a HELOC to invest in real estate. You should be careful and diligent when using your HELOC, and consult with professionals before making any decisions. You should also do your homework and research the market and the property, and follow the best practices to help you succeed in your real estate investing journey.
How to Cut Costs and Fees When Using a HELOC for Real Estate Investing
A home equity line of credit (HELOC) lets you borrow money from your home equity. You can use it to invest in real estate, but it comes with costs and fees, such as:
HELOC lender fees: These are the fees to open and maintain your HELOC account, such as the setup fee, the annual fee, and the interest rate. They depend on the lender, your credit score, your income, your debt-to-income ratio, and your equity.
Property purchase fees: These are the fees to buy the property, such as the closing costs, the appraisal fees, and the transfer taxes. They depend on the property, the seller, and the service providers.
Property ownership expenses: These are the expenses to own the property, such as the property taxes, the insurance premiums, the maintenance and repair costs, and the property management fees. They depend on the location, the value, and the coverage of the property, and the service providers.
Tax implications: These are the taxes that you pay or save on your HELOC interest and your real estate income or gains. They depend on the IRS rules and regulations, and your personal and financial situation.
You can reduce these costs and fees by:
Shopping around and comparing different HELOC lenders and offers: This can help you find the best deal and the best fit for your needs and goals. You can compare the interest rates, the credit limits, the fees and charges, and the terms and conditions of different HELOCs.
Negotiating with the seller and the service providers for the best deals and discounts: This can help you save money and get more value for your investment. You can negotiate the purchase price, the closing costs, the appraisal fees, the property taxes, the insurance premiums, the maintenance and repair costs, and the property management fees.
Performing due diligence and inspections for the property quality and value: This can help you avoid buying a bad or overpriced property, or spending more than necessary on repairs and upgrades. You can perform a thorough research and analysis of the market and the property, and hire a professional appraiser and inspector to evaluate the property.
Budgeting and planning ahead for the HELOC payments and expenses: This can help you avoid overspending or overborrowing your HELOC funds, or missing or defaulting on your HELOC payments. You can make a realistic and detailed budget and plan for your HELOC payments and expenses, and stick to them.
Maximizing the income and returns from the property investment: This can help you offset the costs and fees of using a HELOC to invest in real estate, and increase your profit and equity. You can optimize the rental rates, the occupancy rates, the capital gains, and the tax deductions of your property investment.
Pay back the loan as fast as possible. HELOCs are variable interest and they can have balloon terms. Paying back the loan before the balloon hits can save you thousands.
FAQs
Is a HELOC the same as a home equity loan?
They are not the same. A home equity loan gives you a lump sum of money upfront, while a HELOC gives you a credit line that you can draw from as you need it.
What are the different phases of a HELOC?
A HELOC has two phases: a draw period and a repayment period. During the draw period, you can access the funds and pay interest only. During the repayment period, you have to pay back the principal and interest.
What are my other options for getting access to cash without using a HELOC?
A HELOC is not the only option for investing in real estate. You can also use other forms of financing, such as a cash-out refinance, a personal loan, a hard money loan, or a private money loan. These can have different costs, fees, terms, and benefits.